There is a new competition in trading, with the heat turned up by European regulations that are pushing a huge volume of securities trading on to public exchanges in the name of increasing competition and reducing risk. The winners will be those who can set up new venues with just the right ingredients to attract a big enough slice of that business.

Source: Getty Images

There is no shortage of hopefuls eager to cash in, but there is no quick and easy recipe for setting up a successful trading platform. The process requires a high dose of patience and a meticulous ability to mix together a long list of sophisticated parts.

Hirander Misra, chief executive of derivatives trading start-up Global Markets Exchange Group, said: “Because it is so difficult to get the network effect of a new exchange in terms of members, vendor connectivity and liquidity, typically nine out of 10 new venues don’t quite make it. The key is you need some kind of driver, whether it is regulatory change, or some kind of economic driver that will make that one venue succeed.”

Each of Europe’s newest trading platforms claims to have that special ingredient needed to entice market participants to take their first bite.

GMEX, which was founded by Misra last year and is preparing to start trading, believes it can gain momentum through an innovative swap future contract. The contract seeks to replicate the exposure of over-the-counter interest-rate swaps in an exchange-traded product.

In equities, trading platform Aquis Exchange which started trading in November, is operating a novel monthly subscription pricing model, which departs from the usual maker-taker scheme. The latter offers rebates for orders that add liquidity to a venue and chargers users when their orders remove liquidity from an order book.

Nasdaq OMX’s new derivatives exchange, NLX, is aiming to seduce participants by combining interest products at both ends of the yield curve. Futures giant CME Group is confident its European exchange, CME Europe, will attract liquidity because of the group’s dominance in foreign exchange markets in the US.
But an innovative proposition is only one of the many boxes that must be ticked when launching an exchange, especially in the current environment, marked by tighter technology budgets and busy regulatory compliance agendas, venue chief executives said.

One of the toughest challenges any new venue must overcome remains finding a clearing partner, a facility that stands on either side of every trade as security against a member default.

Related

Niki Beattie, chief executive of consultancy Market Structure Partners and non-executive chairman at Aquis, said: “Clearing is an issue – it’s very chicken and egg – you have to persuade a clearing platform to connect to you but they won’t want to do the work if you don’t have any volumes.”

While this has never been easy, trading executives say the issue is exacerbated by the fact that many of Europe’s clearers are busy achieving compliance with the European Market Infrastructure Regulation.

Emir, which is part of the EU’s response to the G20 post-crisis commitments, requires more types of OTC derivatives to be cleared, while also forcing all central counterparties to obtain re-authorisation by Europe’s financial watchdog.

Clearing has historically been problematic as it can serve as a protective mechanism for incumbent exchanges which own their own clearing houses, such as derivatives operators Deutsche Börse, IntercontinentalExchange and CME Group. These venues force clients to use their clearing houses when trading on their markets.

This is attractive for banks trading derivatives as they can benefit from reduced costs by consolidating clearing in certain products at a single clearing house, while making it harder for start-up venues to compete.

Misra, a former of chief operating officer of alternative trading venue Chi-X Europe, said: “When we were looking at a strategic partner for GMEX, the considerations around the clearing were major factors and that was one of the reasons why, from an investment perspective, Deutsche Börse took a minority stake in us.”

He added that the partnership with Deutsche Börse had opened up the possibility for GMEX to use the German’s exchange clearing house, lowering the barriers to entry.

Aspiring entrants hope the clearing issue will be solved by changes proposed in the Markets in Financial Instruments Directive II. According to the “open access rule”, clearing houses will have to process trades for any markets that request it, and trading venues must let multiple clearing houses clear their trades.

Once clearing is taken care of, a new venue must persuade trading technology vendors to connect to its platform, a costly and complicated process.

Trading venue chief executives say this is one of the toughest aspects of launching in a post-crisis environment, which has seen technology budgets shrink.

Charlotte Crosswell, chief executive of Nasdaq OMX’s NLX, said the problem with starting any new market is that technology resources are currently stretched both with the participants and in the vendor space.

Crosswell said: “You have to sit down and persuade them that this is an exchange they can connect to. With all the regulatory changes and all the things they need to do to comply, obviously that becomes very difficult, because it’s not a ‘need to do’ it’s a ‘nice to do’.”

NLX, which was launched last May, has already achieved 10% market share in its Euribor contract, it said.
Crosswell added: “Generally derivatives start-ups have not done very well over the last few years. And there is nervousness from participants. People do spend nine to 12 months to see whether you are going to be successful or not. They are not going to rush to connect to you.”

But a venue’s success does not rest solely on its connectivity, and even more effort must be made in ensuring that a new platform attracts liquidity.

Beattie said the current hostility to high-frequency trading may make it tougher for new venues to get up and running, as many in the past have relied on initial liquidity from HFT firms.

She said: “There are a lot of political anti-HFT views and the regulation on HFTs is also tightening up. It is going to squeeze the number of people who are likely to want to help feed new platforms, so it’s going to be harder to get new platforms off the ground.”

Getting market makers on board will often mean setting up incentives schemes that will at least neutralise the cost of connectivity.

NLX, for example, gives cash in exchange for trades executed, instead of offering more common revenue-based rebates.

Crosswell said: “If we hadn’t put incentives on the plate last year, so that it at least meant that participants can claw back the cost of connectivity, I think it would have been very difficult to attract participants.”

Similar incentive schemes do, however, require deep pockets, which many newcomers with no large exchange group backers do not have. This leads some independent venues to give out equity to market makers in exchange for their liquidity.

This is more complicated for trading platforms owned by large exchange groups. Yet these can rely on the groups’ established presence in similar products in other markets.

William Knottenbelt, senior managing director, Europe, Middle East and Africa for CME Group, said: “We have the advantage that, in most of these products, we have some liquidity already in the US. So we know the market participants and we will have talked to them beforehand and double checked with them that they think it’s a good idea.”

The venue will launch on April 27 with trading in foreign exchange and commodities futures.

Overall, chief executives at new platforms say a start-up’s fate ultimately rests on how good the proposition is and whether the market is willing to buy in.

Alasdair Haynes, chief executive and co-founder of Aquis Exchange, does not believe the environment is necessarily tougher, rather different in its challenges.

He said: “Your challenges change, but I don’t think things get necessarily more and more tough, I just think you have to be more responsive and more diligent and just go out. We are offering the market a model: the market will decide whether it will succeed.”

--This article first appeared in the print edition of Financial News dated April 7, 2014